Increasing interest rates provides a welcome opportunity for employers with defined benefit pension schemes

With rampant inflation, rising interest rates and a cost-of-living crisis, it’s very easy to think around every corner is something ever more negative. However, David Davison, a Director at pension consultants Spence and Partners, has explained how the upward trajectory of interest rates has created an unexpected opportunity for employers participating in Local Government Pension Schemes (LGPS). Whilst David reports purely on the impact of rising interest rates on LGPS, the principle applies to other defined benefit pension schemes.

20-year annualised inflation peaked at about 4.1% at the end of March 2022, just when most employers were getting their triennial results. However, corporate bond yields (and gilt yields) had also increased - the higher the corporate bond yield, the lower the value placed on liabilities. The increase in corporate bond yields more than offset the increase in inflation, and as such many employers would have seen an improvement in their accounting position.

However, from April 2022 onwards the gap between inflation and gilt yields has narrowed as gilt yields have continued to rise while inflation has come down from its peak, reflecting an expectation of a future reduction as a result of higher interest rates. Most if not all employers will be unaware of the impact.

Participants in LGPS have seen exit debts at record highs over the past couple of years which has meant many organisations have been trapped in schemes that they are unable to afford to exit. These market changes however will have had a very material impact on exit debts; the assumptions used to calculate exit debts are now more in line with the assumptions used for accounting purposes, the latter of which are likely to be significantly smaller given the narrowing of the gap between inflation and gilt yields rates.

If employers are considering an exit from an LGPS, they should be looking at their position at the moment as they need to question if these market conditions are likely to persist indefinitely. The Bank of England’s Monetary Policy Committee meet again on the 15 September 2022 and the expectation is that we could have a further interest rate increase, however further increases will be less likely if and when inflation comes under control.

However, if employers are considering exiting a Scheme, note that this is rarely achieved over a period of less than six months, so if these underlying market conditions are likely to be a temporary phenomenon, then employers need to begin to examine their options now.

Employers in England, Wales and Northern Ireland should be getting their updated actuarial valuations as at 31 March 2022 in the next few months and this would seem to present an ideal opportunity to review their options.

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